Parsing the Yen's Real Depreciation

Change in the real exchange rate depends both on relative rates of price inflation and changes the nominal exchange rate. Consider first the underlying rates of price inflation. Figure 4 [ PDF 125.9KB | 1 page ] plots the paths of the consumer price indexes (CPIs) for Japan, the Euro Zone, and the United States, from 1 January 1999-when the euro officially came into existence- to the last quarter of 2006. Over this eight-year period, inflation was 22.8% in the United States, 18.5% in the Euro Zone, and minus 2.3% in Japan.

Figure 5 [ PDF 125.6KB | 1 page ] then plots the nominal (undeflated) exchange rates for the yen/dollar, the euro/dollar, and the yen/euro. Despite a few ups and downs, the nominal yen/dollar rate was little changed: the dollar had appreciated just 4.7% against the yen from January 1999 through January 2007. By adding the CPI inflation differential to the change in the nominal exchange rate, 29.8% approximates the real appreciation of the dollar against the yen. More precisely, if we double deflate the nominal yen/ dollar rate by the Japanese and U.S. CPIs, Figure 6 shows the actual real appreciation of the dollar against the yen to be 28.7%. Either way, the real appreciation of the dollar came mainly from the 25.1% inflation differential, i.e., the higher inflation in the U.S., and not from the dollar's modest nominal appreciation against the yen.

The story of the yen/euro rate is somewhat different. From January 1999 to the last quarter of 2006, the euro appreciated 19.2% against the yen in nominal terms-as shown in Figure 5. If the CPI inflation 20.8% differential between Japan and the Euro zone (Figure 1) is added to this nominal euro appreciation, the approximate real appreciation of the euro against the yen is close to 40%. When the real exchange rate is calculated more precisely by double-deflating the nominal exchange rate by the CPIs in Japan's and the Euro Zone, Figure 6 shows the euro's real appreciation against the yen to be 43.7%. Thus the euro's more visible nominal appreciation was almost as important as the inflation differential in explaining the euro's large real appreciation against the yen, which now so irritates European mercantile interests and their governments.

Changes in the euro/dollar exchange rate have been less dramatic. From January 1999 to January 2007, the euro appreciated against the dollar by 12.1% in nominal terms (Figure 5), and by 10.4% in real terms (Figure 6 [ PDF 126.7KB | 1 page ]).This real appreciation of the euro against the dollar was slightly muted because CPI inflation in Europe was moderately lower than in the United States (Figure 4). Although some Europeans -notably the makers of Airbus aircraft- are worried about the relatively small decline in the dollar, most see Japan with its weak yen to be the greater mercantile threat to European heavy and high-tech industries.

Unit labor costs. To check on these calculations of "real" exchange rates deflated with broadly based CPIs, consider the OECD's estimated unit labor costs more narrowly in manufacturing -the only sector for which comparable quarterly data are available across all three areas. Unit labor costs are wage costs in local currencies less productivity growth per unit of output.

Figure 7 [ PDF 103.1KB | 1 page ] compares the course of manufacturing wages in Japan, the Euro Area, and the United States from the first quarter of 1999 through the fourth quarter of 2006. American nominal wages in manufacturing rose by 24%, European by 27.8%, and Japanese by only 7.9%. Figure 8 [ PDF 102.4KB | 1 page ] then shows that Japanese unit labor costs fell by 24.2%, whereas those in the Euro Area fell by just 3% and those in the U.S. by 5.9%. (Although this general fall of unit labor costs in manufacturing is striking, it need not hold in other sectors within our three economies.) Thus, manufacturing unit labor costs in the Euro Area rose relative to those in Japan by 21.3% percentage points. But on top of this, the euro appreciated in nominal terms against the yen by 19.2% (Figure 5). To be more precise, double-deflating the nominal yen/euro exchange rate with manufacturing unit labor costs, Figure 9 [ PDF 123.8KB | 1 page ] shows the "real" appreciation of the euro against the yen to be a remarkable 55% from early 1999 through the fourth quarter of 2006.

Can this increase in Japan's international competitiveness be explained by its superior productivity growth? Somewhat surprisingly, from first quarter 1999 to fourth quarter 2006, manufacturing productivity growth rates across all three areas were similar. Changes in labor productivity can be backed out of the OECD data on wages (Figure 7) and unit labor costs (Figure 8) to show that growth in labor productivity was 32.1% in Japan, 29.9% in the U.S., and 30.8% in the Euro Area. Although the euro zone's slightly lower productivity growth (1.3 percentage points in manufacturing) contributed to its loss of competitiveness relative to Japan, this effect was dwarfed by the euro's nominal appreciation of 19.2% against the yen, and by European wage growth being 19.9 percentage points higher than Japan's.

Based on unit labor costs, the dollar's real appreciation against the yen was "only" 22.7% (Figure 9), but still very substantial. However, most of the loss in U.S. competitiveness relative to Japan came from the faster growth in U.S. wages, or, to put it differently, wage stagnation in Japan. From 1999 through the fourth quarter of 2006, American wages grew by 16.1 percentage points above their Japanese counter parts in manufacturing when U.S. productivity growth was only 1.2 percentage points less.

To erase any doubt about the persistent deflationary pressure on prices and wages in Japan, Figure 4 showed a 2.3 percent fall in Japan's CPI from 1999 to fourth quarter 2006. Beyond just manufacturing, Figure 10 [ PDF 105.1KB | 1 page ] provides comparable wages across the whole of the private sectors of Japan, the United States, France, and Germany. (No such general series was available for the euro area as a whole.) Japanese nominal wages actually fell by 3.4% while those in the U.S. rose by 27.8%, by 33.4% in France, and by only 16.5% in Germany. And wage deflation in Japan continues. The Economist Intelligence Unit (June 2007, p. 27) reports that in April 2007, monthly cash wages per worker in Japan actually fell 1.4% compared with a year earlier. Wage deflation in Japan continues to be unique relative to the other large industrial countries.

Does this persistent wage stagnation simply reflect Japan's low or non-existent GDP growth during its lost decade after the stock and land bubbles burst in 1990-91? Perhaps not. Remarkably, from 2003 through 2006, when Japan's real output and GDP growth finally began to grow a modest 2 percent per year (Figure 11 [ PDF 125.2KB | 1 page ] shows nominal GDP growth), Japanese money wages still fell in private industry generally. Because Japan's unit labor costs continue to fall from wage stagnation, Japanese exports became even more competitive in world markets -thus triggering the return to Japan bashing in 2007.

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